Fundies find it tough to be bearish after ASX survives wild first quarter

Airlie's John Sevior says the big caps are struggling with growth, a theme that has marked the first quarter.
Photo: Rob Homer

As the Australian equity market heads for a flat finish to the first quarter of 2016, what began as the worst-ever start to a year seems even more perplexing now that regular service has been restored.

But fund managers, reliably as ever, can look forward in the knowledge that one correction a year is unlucky – and sometimes necessary – but two corrections are unlikely.

The problem is that there is no fire sale on quality and even at 5142 points – the same level as 2006 – good stocks are not cheap. Indeed, the impulse to sell over-valued defensive stocks has been curbed by the realisation that on the old risk-reward dice roll, there is nothing better to buy out there.

The staggering returns achieved by some companies already in 2016 says more about the trading mentality that has taken over than any sensational revelations about the bedrock of the equity market.

There is terrific money to be made for investors with impeccable timing and an instinct for the next hot momentum stock.

"I think the scary thing from my point of view that the first quarter has highlighted is how much of an air pocket quantitative easing has put in terms of valuation that's risen as a result of people reaching for yields," Thomas Hodson, senior investment analyst at Wingate Asset Management, says.

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"When there's a crack or a shock to the confidence, the valuations can fall very quickly," he says.

Difficult to justify

Extraordinary monetary policy, which stepped up in the first quarter, with negative interest rates introduced in Japan and deepened in the eurozone, makes the "enormous premium" on risky assets difficult to justify without earnings growth, he says.

"The things that are safe are expensive, so you need to really think carefully about what you own, and the things that are cheap tend to have some warts and hairs and other sorts of things going on, so you need to be comfortable with that side of the equation as well."

The top 20 stocks in particular have a growth problem, a theme that became entrenched in investor thinking in 2015 and has continued into 2016, weighing on the blue chips' share prices.

The S&P/ASX 200 index is down 2.9 per cent for 2016, which means it is out of bear market territory. It follows a 5.5 per cent gain for the December 2015 quarter, which was on the tails of an 8 per cent loss in the September quarter. On Wednesday it closed down 0.5 per cent. Volatility, it seems, is here to stay.

The big caps are struggling for growth, with 15 per cent of the market by dollar value delivering 30 per cent of the earnings upgrades over reporting season. "That's makes sense," John Sevior, founder of Airlie Funds Management, says.

"The bigger companies have all got big issues, whether it's the banks with a slower lending environment, or Woolworths with its own issues or resource companies with falling commodity prices.

"The better companies that don't have any legacy issues or problem children in the pack tended to sail along pretty well."

Harder to come by

Callum Burns, a portfolio manager at SG Hiscock & Company, says: "I think we've seen a test due to the fact that the penny's dropped that earnings growth is much harder to come by than we've all become used to in our various investment lives and we just need to be more discerning."

As Warren Buffett's investment partner Charlie Munger said: "Anybody who is intelligent who is not confused doesn't understand the situation very well. If you find it puzzling, your brain is working correctly."

That must come as a relief for the rest of the smart guys in the room, who are still trying to figure out how markets snapped on so few new developments. The one thing everyone can agree on is the origins of the sell-off are entirely macro.

"There's plenty to worry about in the world," Raaz Bhuyan, from WaveStone Capital, says. And equally, plenty to counter that pessimism, he says.

"Between the two bookends – central banks running out of ammunition, negative interest rates, strong US dollar draining liquidity, Chinese devaluation and hard landing leading to global deflation, recessionary conditions on one side, and dollar and oil price stability, low inflation and hence interest rates, China transitioning on track, reasonable global growth at the other end."

The February earnings season could not have come at a better time.

"It's hard to be too negative on the domestic economy when retailers like Harvey Norman and Bunnings are delivering strong sales," Bhuyan says.

But if the recovery in the ASX 200 was just mean reversion, can the market advance without a sustained recovery in commodity prices? "Most of the commodities [for example, iron ore] are well supplied and therefore prices should be more linked to the cost of the marginal producer. In that environment, long-run prices will likely be more muted. Hence, it is hard to see a rally in commodities driving the ASX for the rest of the year," he says.

The message is, while the ASX has passed its first-quarter stress test, it is not time to celebrate the result just yet.

"It's just a first-term result," Burns says. "There's still a bit more study to do before the final exam."